Reform and Regulation of Derivative Transactions

Peter Malyshev is counsel at Latham & Watkins where he focuses his practice on regulatory, compliance and transactional issues relating to commodities, securities and derivatives products markets.

Latham has registered several Swap Execution Facilities (SEFs) to date and advises regarding SEF trading market participants, which range from large banks, commodities and derivatives traders, and equity funds to non-financial institutions and commercial hedgers.

“The effect of the Dodd-Frank Wall Street Reform and Consumer Protection Act was profound,” said Malyshev. “Before these reforms, the derivative swaps market was over the counter. Now the entire market, which is in the trillions of dollars, is regulated.”

How is the market coping with the transition to regulated derivative transactions?

Malyshev: In 2010, the Dodd-Frank Act became effective. The Act ensures that standardized derivatives trade on either designated contract markets, such as exchanges, or on SEFs. For the past three or four years, derivatives trading facilities — which were mostly unregistered — went through the process of registration and are now operational in the US markets as SEFs. There are about 20 or so of these facilities. The challenge for the market is to bridge the gap between over-the-counter trading in derivatives and the new regulated format.

This is particularly relevant in the context of clearable contracts, such as interest rate swaps and credit default swaps as well as other contacts that the Commodity Futures Trading Commission (CFTC) will designate as clearable in the future. We expect that by the end of 2014, foreign exchange contracts, most standardized precious metals contracts and energy contracts will be designated as clearable. If a contract is clearable, you must trade it on a SEF by law; it is illegal to trade them off of these facilities.

The SEFs themselves must figure out how to comply with these requirements and what they need to do to remain registered with the CFTC. And numerous market participants which, before these facilities became available, were trading in an unregulated market now need to trade swaps and hedge their exposure on the regulated markets, such as SEFs.

What are the biggest challenges facing the industry over the next six to 12 months?

Malyshev: There are so many issues, that they touch upon almost every rule promulgated by the CFTC in the past several years. This year market participants will focus on the implementation, and the CFTC will start ramping up their enforcement efforts as well — we are already seeing some of this taking place.

Among other things, I think that anything related to SEFs is up for debate because the industry is looking at ways to implement these regulations to comply and to ensure that they continue their business operations within the framework and the timeframe that the CFTC has provided. And that’s a huge challenge.

In addition to SEFs, one of the big areas of concern in 2014 is position limits because that is something that every participant in commodities and derivatives should be aware of. The rules are not final yet, but they will be soon.

Other challenges include the completion of the required documentation, including master agreements, etc. And bringing the end-user community, which is not accustomed to being regulated, into the regulated space.

Reporting, of course, will continue to be a developing area as well as CFTC’s cross-border rules and harmonization of its regulations with the international regulators.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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